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The Market's 10 Best Stocks ... Cheap!

How two great investors profit from a market anomaly.

The strategy went mainstream in 1989 at Fidelity, and over the past 10 years, it's smoked its benchmark to the tune of 4 percentage points per year.

Respected investment shop Royce & Associates copied the strategy four years later -- and it, too, is beating its small-cap benchmark and the broader market over the past decade.

A seemingly unstoppable market-crushing strategyBefore we get to the secret that both Fidelity and Royce have been using to enrich their shareholders for years, it's worth restating that the only way to make money investing in individual stocks is to see things in the market that the rest of the world's investors do not.

That's a tough act, and it takes years of practice to perfect. The best way to get started, however, is to simply start looking at stocks that no one else is even considering.

What's their secret? You've likely already guessed it, given their names, but both of these funds invest solely in low-priced stocks.

Fidelity manager Joel Tillinghast defines that universe as stocks trading for less than $35 per share. For Royce manager Whitney George, it's less than $25. But don't let those parameters fool you. Because of the way mutual fund regulations work, it behooves companies to define their strategies broadly. I have it on good authority, however, that the key to this strategy is to concentrate on finding stocks trading for less than $10 per share.

Why does this work?The low-priced stock universe is a rich stomping ground for investors willing to do close and careful research. Quoting the Royce fund's prospectus: "Institutional investors generally do not make very low-priced equities (those trading at $10 or less per share) an area of their focus, and they may receive only limited broker research coverage. These conditions create opportunities to find securities with what Royce believes are strong financial characteristics trading significantly below its estimate of their current worth."

This is not to say that every low-priced stock is an opportunity. The reason the universe is so ignored is because most of the stocks trading at these prices are garbage. But as Royce's managing director Jack Fockler told me recently, "If you apply rigorous quality standards to a universe people write off as junk, you can find some really interesting things."

"Interesting" being a euphemism for "incredibly profitable"Armed with this information, I went back and took a look at my list of the 10 best stocks of the past 10 years. While I already knew that all of them started off as small companies, I hadn't looked to see where their stocks were trading a decade ago.

This, however, is clearly a universe of stocks with a lot of potential, as well as one ripe with inefficiencies ... as you can see from this comparison of the institutional ownership and analyst coverage for "ownable" large caps ...

Company

Market Cap

Recent Price

Institutional Ownership

No. of Analysts Following

EOG Resources(NYSE:EOG)

$21 billion

$74.71

99%

29

CVS(NYSE:CVS)

$38 billion

$26.39

85%

22

Target(NYSE:TGT)

$21 billion

$28.08

109%*

22

*Total shares outstanding can exceed 100% because reporting requirements for holdings data is not aligned with the financials reporting of shares outstanding.

... versus "un-ownable" small caps:

Company

Market Cap

Recent Price

Institutional Ownership

No. of Analysts Following

NamTai Electronics(NYSE:NTE)

$219 million

$4.89

43%

4

International Asset Acceptance (NASDAQ:IAAC)

$63 million

$7.00

55%

0

Craft Brewers Alliance (NASDAQ:HOOK)

$12 million

$1.52

8%

0

Data from Capital IQ and Thomson Financial.

Potential and inefficiency. Put those traits together in the stock market, and -- as Fidelity and Royce have proved -- you can make a lot of money.

But buyer bewareAll of this said, for every small, low-priced stock that becomes a multibagger, there are many more that don't make it. That's a key reason both Tillinghast and George, two of the smartest investors in the space, are widely diversified in their funds.

So if you're ready to start learning more, or even employing this low-priced strategy, make sure you do so within the context of a diversified portfolio.

You can also take a look at our Motley Fool Hidden Gems small-cap investing service, where we specialize in finding small, overlooked stocks with sound fundamentals, solid business plans, and big potential.

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This article was first published on March 6, 2008. It has been updated.

Tim Hansonowns shares of Nam Tai and IAAC. Nam Tai is a Motley Fool Global Gains recommendation. Apple is a Stock Advisor pick. The Fool's disclosure policy has run out of clever things to say.